December 06, 2005

Money Supply, M3

Money Supply, M3, Conspiracy Theory

I started to do a piece on the nature of the Internet. What I had in mind is that the Internet is a vast repository of facts, opinions and fiction disguised as fact. In a sense, the problem is that Google does not separate search results by fact, opinion, and fiction. A consequence is that someone can do a search on a topic and be unfamiliar with the sources and reach an erroneous conclusion about what is going on. For example, the Federal Reserve has announced that in March 2006 it will stop reporting M3 (a broad measure of money supply). What does this mean? I will devote this newsletter to discussing money supply and next week (or the week after) will talk about what is wrong with the Internet and the blending of fact, opinion an fiction.

Every Thursday the Federal Reserve releases a report on the money supply. There are 3 money supplies: M1, M2, and M3.

M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) travelers checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. Government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions.

M1 is money ready to be spent. It buys groceries and gas for the car and pays the rent or mortgage.

M2 buys groceries and gas for the car and pays the rent or mortgage plus it buys the car and makes a down-payment for the house. It also is a source of capital investment.

(If you cannot see the graph - I am trying graphics here for the first time-) it may be found at http://research.stlouisfed.org/fred2/data/M2_5yrs.png

M3 consists of M2 plus (1) balances in institutional money market mutual funds; (2) large-denomination time deposits (time deposits in amounts of $100,000 or more); (3) repurchase agreement (RP) liabilities of depository institutions, in denominations of $100,000 or more, on U.S. Government and federal agency securities; and (4) Eurodollars held by U.S. addresses at foreign branches of U.S. banks worldwide and at all banking offices in the United Kingdom and Canada. Large-denomination time deposits, RP's, and Eurodollars exclude those amounts held by depository institutions, the U.S. government, foreign banks and official institutions, and money market mutual funds.

M3 consists of M2 - the money in play in the U.S. economy and two other big ticket items: Eurodollars, which are not in play and RP's which are in play, theoretically, only in the short term. Much of M3 is not "money in play" in the economy. Eurodollars are not and large-denomination time deposits are held by folks with wealth who have no intention to spend those dollars any time soon. RP's are more difficult to get a handle on. These are short-term borrowings but if they keep getting loaned out they are in play. In fact, the entire purpose of RP's is to put dollars in play.

(If you cannot see the graph - I am trying graphics here for the first time-) it may be found at http://research.stlouisfed.org/fred2/data/M3_5yrs.png)

The most commonly watched money supply is M2.

Eurodollars

Eurodollar are dollar denominated assets held at financial institutions outside the United States and, consequently, not under any regulation by the Federal Reserve. Subsequent to World War II the U.S. started pouring money into Europe for rebuilding. That money was in the form of dollars and those dollars stayed in Europe. During the 1960's the Soviet Union became a holder of dollars and feared seizure of those dollars if they were kept in US banks. British banks agreed to hold those dollars for the Soviets and make deposits in U.S. banks in dollars. In essence the Soviets were able to hold dollar based assets satisfied of their safety.

The popularity of such transactions has expanded vastly. The expression "eurodollar" is now used to refer to any currency held outside its native country and banking system.

When the Federal Reserve uses the term "eurodollars" they refer to U.S dollars held outside their control. That could be dollars held in foreign countries including dollars held by U.S banks in branches outside the U.S.

A current topic of discussion is why the Federal Reserve is dropping regular reporting of M3 - a measure of the money supply which includes Eurodollars. Presumably the Fed does not regard those dollars as being "in play" in the U.S. economy. In short, the substantial increase in Eurodollars has not had an inflationary effect (too many dollars chasing too few goods) in the U.S. Those dollars are not really doing any chasing of goods with the exception, perhaps, of real estate of both coasts.

Repurchase Agreements

The following 2 paragraphs are from the web site for the Federal Reserve Bank of New York:

Among the tools used by the Federal Reserve System to achieve its monetary objectives is the temporary purchase and sale of United States Government securities and federal agency obligations in the open market.

In conducting these operations, the System uses "repurchase agreements" ("RP's" or "repos") and "reverse repurchase agreements" transactions which have a short-term, self-reversing effect on bank reserves.

Such repurchase agreements are instigated by the Fed's trading desk for the purpose of controlling money supply. In theory, they are used to offset day-to-day fluctuations in bank reserves. In would seem to me that repos should be included in regarding the money supply and regularly reported. Nevertheless more attention has always been paid to M2 than M3 so dropping the regular reporting of M3 is not exactly drastic. The Fed has not used money supply but rather interest rates to spearhead monetary policy for the past 20 years. The fact that M2 and M3 have increased so dramatically with modest inflation speaks volumes to this disconnect.

Comments

Some think our economy is solid, I have doubted it and doubt it more after reading this article. I guess Spring 2006 will tell.

A Story About Oil You NEED To Hear
by Soj
Tue Dec 27, 2005 at 09:57:25 AM PDT
Some news stories are screamed in 100 headlines in 100 different newspapers and media outlets. This one however is so quiet it's almost a whisper, yet it may be one of the biggest stories next year.

Soj's diary :: ::
It all begins here, with a blurb so tiny that I'll reprint the entire thing. From the Federal Reserve's website, November 10, 2005:

On March 23, 2006, the Board of Governors of the Federal Reserve System will cease publication of the M3 monetary aggregate. The Board will also cease publishing the following components: large-denomination time deposits, repurchase agreements (RPs), and Eurodollars. The Board will continue to publish institutional money market mutual funds as a memorandum item in this release.

To fully understand how the "Federal Reserve" is neither federal nor a reserve of anything of value, see my full-length story here.

But what is the M3? And how is it relevant?

The Fed collects data on how much money is in circulation, where it's being stored (as cash, as stocks, etc) and prints these statistics on a quarterly basis. These are the "M" series of reports.

M0 (M Zero) is simply how much physical American money is in circulation, both coins and bank notes. M1 is M0 plus all the money that's in a bank that someone could withdraw immediately (usually known as "checking" accounts). M2 is M1 plus other types of accounts, including money markets and smaller CDs (under $100,000).

M3, the one that will no longer be printed, is M2 plus Eurodollars. While Eurodollars sounds like plastic money used at EuroDisney, it actually refers to dollars being held in non-American banks (originally most dollars held overseas were in European banks, but "eurodollars" could just as easily be held in China).

I for instance have some "eurodollars" since I live in Romania and have a few bucks in the local bank. But 99% of American money being held outside its borders are actually under the control of central banks and large institutions.

Why does this matter? Why would keeping track of how many dollars are being held overseas matter to anyone except perhaps some bankers?

The answer has to do with oil. Texas tea. Black gold. The stuff which wars are fought over, and alliances made to crush human rights in order to obtain a steady supply of it.

While oil can be drilled and refined and transported anywhere, there's only two places where it can be officially purchased. One is in New York City on the NYMEX stock exchange and the other in London on the IPE exchange. I should mention that London's IPE is actually now owned by an American country named "ICE".

This doesn't mean that oil actually has to be transferred from say, Saudi Arabia, to New York where it sits in a real barrel until it's sold to a customer in Japan. What it does mean however is that oil is traded like any commodity, via these two (and ONLY these two) stock exchanges. There are also "futures" or promises of future oil deliveries sold and traded as well.

So the customer in Japan, perhaps a large oil refinery company, buys the oil "shares" via one of the two exchanges from one of the oil owners, a company such as ExxonMobil or Saudi Arabia's ARAMCO. And while the oil itself never actually gets to London or New York, all the money involved flows through those two cities. And every single barrel of oil is bought and sold in American dollars.

This means that every single country which wishes to buy oil has to own dollars to do it. Since these dollars are held overseas, they are referred to as Eurodollars, although once again they don't have to be in Europe. A dollar in China is a dollar in America too - they aren't valued any differently.

The world sells and buys billions of barrels of oil per day, and every single one of those billions is in the form of an American dollar. The effect of this is that every single country in the world which holds large reserves of dollars (for the purpose of buying oil) is essentially propping up the American economy on a huge scale.

If you read my full-length article on the dollar, you will know it's not worth anything of intrinsic value. It isn't backed by gold, or even by the American government. It's simply a piece of paper (or blip on a screen) that everyone "believes" has worth. So a country like Saudi Arabia ends up selling their tangible resource (oil) in exchange for billions of pieces of green paper (dollars).

Those little pieces of green paper, in order to make them worth anything, must then be traded for something of value. That could be anything from food to cars to high-tech weaponry.

Think of it this way. Imagine that the world was one very large casino. Players could trade in oil or food or electronic equipment for chips that are manufactured and designed by the casino itself. The chips aren't worth anything by themselves, as they're just painted pieces of plastic. But for any player to cash out, they need to redeem the chips for tangible goods made by the casino, at the rate that the casino sets. If you swap "casino chips" for "dollars", that's a pretty good way to understand how the system works.

Another way to think of it is that every drop of oil is worth a portion of a dollar, meaning oil is dollars and vice versa. Which means that all the vast wealth that is oil is in effect, also adding that wealth to the United States.

So back to the Fed and their decision to stop reporting the holdings of dollars overseas. Why does that matter?

There is a lot of speculation out there, but one good guess is that Spring 2006 is when Iran's oil bourse will debut.

I wrote an entire article about it which you can find here but here is an excerpt:

Iran is a member of OPEC, which currently restricts all foreign sales to the American dollar. So is there any way for Iran to start selling its oil without having to resort to the currency of its foe?

The answer is close to completion and yet I've seen almost no mention of it in the American mainstream media. If it wasn't for the trade journals, I'd never even have heard of what Iran has planned.

In June 2004, Iran announced it was creating an oil bourse. The word "bourse" is a French word which means "exchange" and refers to an international market exchange where oil can be traded. Currently the only two oil bourses are in London and New York.

Should Iran's oil bourse be successful and sales be denominated in Euros, this will induce hedging of the Euro versus the dollar and fundamentally alter the prices of oil. Some reports show that both China and Russia, large trading partners with Iran, have begun to increasing their holdings of Euros.

Iran had originally scheduled to open its bourse (or stock exchange where oil could be sold and bought in Euros) in 2005. That obviously hasn't happened, but now the date is set for Spring 2006. Exactly when the Fed says it will stop printing statistics of how many dollars are in existance overseas. In fact, just this week the Iranian government has issued preliminary licenses to trade on that bourse.

What's not well known is that Saddam Hussein decided to switch from selling Iraq's oil in dollars to Euros in November 2000. This was not widely reported. At the time, Iraq's oil sales were limited and were under UN supervision (as part of the "Oil for Food" program) so the sale in Euros did not have a major impact.

According to the Ithaca News, one of the top 10 stories that the press should've reported in 2005 but didn't was Iran's oil bourse:

The Bush administration has been paying a lot more attention to Iran recently. Part of that interest is clearly Iran's nuclear program - but there may be more to the story. One bit of news that hasn't received the public vetting it merits is Iran's declared intent to open an international oil exchange market, or "bourse."

Not only would the new entity compete against the New York Mercantile Exchange and London's International Petroleum Exchange (both owned by American corporations), but it would also ignite international oil trading in euros.

"A shift away from U.S. dollars to euros in the oil market would cause the demand for petrodollars to drop, perhaps causing the value of the dollar to plummet," Brian Miller and Celeste Vogler of Project Censored wrote in Censored 2006.

"Russia, Venezuela, and some members of OPEC have expressed interest in moving towards a petroeuro system," he said. And it isn't entirely implausible that China, which is "the world's second largest holder of U.S. currency reserves," might eventually follow suit.

"Barring a U.S. attack, it appears imminent that Iran's euro-dominated oil bourse will open in March, 2006," Miller and Vogler continued. "Logically, the most appropriate US strategy is compromise with the EU and OPEC towards a dual-currency system for international oil trades."

I'm not enough of an economist to be able to predict the impact on the removal of the dollar as the sole currency for the purchase of oil, but there are plenty of experts who predict some pretty scary things, the least of which is a massive destabilization of the American economy.

What's interesting is that plenty of people will tell you that Iran's bourse is of no threat, and not even financially viable. This however reminds me of a Radio Free Europe story on Saddam Hussein's move back in 2000:

Iraq is going ahead with its plans to stop using the U.S. dollar in its oil business in spite of warnings the move makes no financial sense.

Baghdad this week insisted on and received UN approval to sell oil through the oil-for-food program for euros only after 6 November. Iraq had threatened to suspend all oil exports -- about 5 percent of the world's total -- if the body turned down the request.

The move comes despite repeated cautions that Baghdad's departure from the oil industry standard of the dollar will cost the country millions in currency conversion fees. UN officials have said Iraq will have to reduce the price of its crude oil by about 10 cents a barrel in order to compensate buyers for the additional costs.

But Saddam Hussein profited handsomely on the conversion, especially because the Euro rose approximately 17% in value. The Euro, which at the time was 82 cents to the dollar, is now worth about $1.25 and could easily rise if its value becomes connected to oil on a large scale.

As I've written about extensively, there are plenty of reasons for the Iranian and American government to be at loggerheads. They certainly represent wildly different political ambitions and they will clash for a number of different reasons, not solely due to the threat of selling oil for euros.

That being said, it does seem ominous that the Fed wants to stop printing the statistics of how many dollars are being held overseas precisely when those amounts may go down dramatically. So far this story has been restricted to a few financial websites and "tinfoil hat" locations but definitely needs to be brought into the mainstream so it can be analyzed and debated.

For a more financially-based interpretation of the Fed's ending of the M3, see here, including this:

M3 is very important. Indeed of the Fed's monetary numbers only M3 was of major importance and in other G7 countries we also focus on M3 including our own Bank of Canada. No word that they intend to follow. So why are they dropping M3? Well we have seen nothing to tell us why we only know they are doing it. Oh it's not that the numbers will completely disappear. For those that wish to take the time they can pore through the Flow of Funds accounts (released quarterly as Z.1 release and the H.8 bulletin released weekly for commercial banks) and piece together the former M3. Painstaking, but that is not the way it is supposed to be. European Central Bankers put great stead in M3 so why has the Fed after all these years decided to cease publication?

Some of the reasons we have seen floated around are as follows:

History has shown that only failing economies e.g. Soviet Union keep data secret (Financial Sense - Toni Straka - Unpleasant M3 Trend, November 12, 2005). An interesting premise and a theme we saw woven amongst a number of writers is that they have something to hide. The claim is that the Fed should be transparent and by not publishing the number the Fed now lacks transparency.

The end of publishing of M3 in March 2006 coincides with the start of the Iranian Oil Bourse. The premise here is that the with the oil bourse trading in Euros there will be a rush out of US$ into Euros and that M3 could drop sharply. A sharp drop in M3 would of course presage a recession as falling M3 is a characteristic of weak economic periods.

M3 is a measure of inflation in the economy. A somewhat unproven rule of thumb is GDP + inflation = M3. Will be able to properly measure inflation going forward if we don't know what M3 really is.

We are about to enter a period of hyperinflation and by eliminating M3 we will not know how much liquidity the Fed is pumping into the system. Remember the Fed doesn't really print money it is the banking system that expands money supply. But the Fed influences it through open market operations. We will have to watch daily Fed repo action very carefully irrespective of whether they are going to publish Repos (RPs) as noted in the bulletin above. The Fed doing repos puts money into the system and the Fed doing reverse repos takes money out of the system. Of course as well this is the exact opposite of the collapse in M3 premised with the oil bourse above.

Further on the theme above a period of hyperinflation would occur as the Fed tries to save us from a collapsing housing market and softer consumer demand. The Fed adds more and more liquidity to the system to stave off a sharp economic decline. By not publishing Repos (RPs) as noticed in their bulletin above the Fed again is hiding what they do on a day to day basis. This will make it difficult for both currency traders and equity traders to know what the Fed is up to.

The conclusion is that the Federal Reserve will be hiding a debasement of the US$.

The Fed is still publishing repo info even though they may have stopped publishing M3. Folks whom I know who look at money supply as an indicator of what's happening with the economy have always placed more weight in either M2 or flow of funds.